Stock gains were broad, depending on size and style. Small-caps outperformed large-caps and a number of U.S. stock indexes posted gains of nearly 2%. On average, the Magnificent 7 rose 1.8%, while the S&P 500 rose 1.9% to 4,318, as 89% of the index’s constituents ended the day higher.
Meanwhile, the 10-year U.S. Treasury yield fell 10 basis points to 4.66%. Ten-year U.S. Treasury yields have fallen rapidly since October 23, when the yield last rose above 5.0%. Lower interest rates provide relief for stocks in a weakening economic environment. As of Tuesday’s close, Federal Reserve funds futures markets have priced in cuts of 75 basis points by the end of 2024, up from 50 basis points.
Stocks are expected to hold on to gains on Friday, with S&P 500 futures down just 0.1%. This came despite disappointing results from Apple, which gave holiday quarter sales forecast below market expectations.
The FOMC remains committed to being cautious in its future interest rate decisions as the process still has a “long way to go” to bring inflation down to 2%. The Fed reiterated that further interest rate hikes could not be ruled out, but noted that “tighter financing conditions” would weigh on the economy.
What do we expect?
Until this week’s rebound, stocks had been on the defensive since their 2023 peak in late July. Several factors contributed to this weakness, causing the S&P 500 to fall over 10% last Friday – the common definition of a correction. More robust U.S. economic data suggested Fed rates would remain higher for longer, with the possibility of a final rate hike before the end of the cycle. Rising yields on longer-dated Treasury bonds, driven in part by increasing U.S. Treasury issuance, created additional headwinds. This increased the relative attractiveness of risk-free fixed income securities at a time when other equity valuation metrics also appeared challenging. Finally, while third-quarter earnings were overall positive, they also included some disappointments from the mega-cap technology and growth companies that have led the 2023 rally. The S&P’s revival this week reflects improving sentiment on several fronts.
First, the Fed meeting on November 1 reinforced hopes that the end of the tightening cycle may already be reached. While the Fed’s decision not to raise interest rates for the second straight day was expected, the tone of the accompanying statement appeared to be more balanced. In particular, policymakers noted that “tighter financing conditions” would weigh on the economy – reinforcing recent comments from senior officials that higher Treasury yields could reduce the need for additional interest rate hikes. Of course, there is a risk that Fed officials’ emphasis on tightening financial conditions could lead to them being eased again as yields fall. Overall, the outcome of the meeting reinforced our view that interest rates are nearing a peak and markets have gone too far to price in a “longer-term higher” scenario.
Second, the upward momentum in yields was interrupted by the US Treasury Department’s decision this week to curb the growth of longer-term bond issuance. The move came in response to 10- and 30-year Treasury yields rising to their highest levels since 2007. While the government will continue to increase auctions of longer-dated bonds, it will do so at a slower pace. a stronger focus of issuance on 2- and 5-year bonds. While this shift alone would not be enough to curb the rise in long-dated yields, it highlighted that policymakers are prepared to take action to address the risks of too rapid a rise in interest rates at the bottom of the curve. This is consistent with our view that the Fed and Treasury are interested in addressing issues in the functioning of financial markets given the consequential risks to financial stability. Given the prospect of slower economic growth in 2024, we expect the 10-year U.S. Treasury yield to decline to 3.5% from the current 4.68% by June 2024.
Third, while U.S. economic data remains mixed, investors have focused on signs of a slowdown in recent days. The ISM survey for October fell to 46.7 – the weakest reading since July after three months of better activity. The index is now below the 50 mark, marking a decline since last October. And on Thursday, U.S. jobs data showed productivity posted its sharpest rise in three years, easing worries about wage-related inflation. Current jobless claims have also increased for six straight weeks, suggesting that Americans who lose their jobs are having more difficulty finding new work. Many economic data remain robust. However, we expect growth to slow in the coming months as previous Fed rate hikes weigh more heavily on interest rate-sensitive sectors such as real estate and auto sales. Households are grappling with the end of child care subsidies, reductions in Medicaid payments and the resumption of student loan payments. Additionally, we expect savings rates, still near historic lows, to rise as confidence weakens.
Fourth, the recent decline in yields is likely to support stocks in general and, in particular, longer-term assets such as growth stocks. These include the leading US technology and growth companies – the so-called Magnificent 7 – which have led much of the rally in 2023. This group has recently come under pressure after mixed third-quarter results dampened optimism about earnings momentum. Although overall results were positive, the results and forecasts from automaker Tesla and internet company Alphabet disappointed market forecasts. Most recently, Apple warned on Thursday that holiday sales would likely be below market expectations. However, lower yields reduce headwinds for longer duration stocks, whose valuations are more dependent on future earnings.
Fifth, the correction in stocks had begun to make valuations appear more attractive. At the start of the week, the S&P 500 was trading at about 17 times 12-month forward earnings. Without taking the Magnificent 7 into account, this value was closer to 15x. In our view, such multipliers seemed quite reasonable given our base case scenario of a soft economic landing. It is too early to say whether the recent improvement in conditions will be sustained. A too-strong October jobs report on Friday could reignite fears that interest rates will stay higher for longer. However, we see a positive return outlook for stocks over the next six to 12 months, supported by a soft landing in the U.S. economy and our forecast for 9% earnings per share growth for S&P 500 companies in 2024.
How do we invest?
Given the total returns on offer and the likely capital appreciation as inflation cools, growth slows and Fed interest rates peak, we maintain our preference for the higher quality segments of fixed income. We favor premium (government) and investment grade bonds and are neutral on high yield and emerging market bonds.
We take a neutral view on global equities. While we see upside potential over our forecast horizon – in the US, for example, we expect the S&P 500 to reach 4,500 by June 2024 and 4,700 by December 2024 – uncertainty about the monetary policy outlook could keep markets in a choppy ebb for now. We recommend focusing on areas that have underperformed in this year’s rally, such as emerging market stocks.
Given the recent selling pressure in the technology sector, we believe investors considering adding exposure can look to beaten-down AI beneficiaries such as select global semiconductor stocks. The latest technical results confirm robust future investments in AI infrastructure and support our expectation of a significant revenue recovery next year. As AI demand increases, we continue to like mid-cycle technology segments such as software and internet: We expect new AI-powered productivity tools such as Co-Pilots or generative design tools to drive adoption in the coming quarters and increase direct AI revenue .
Overall, we continue to believe that this continues to be a good environment for investors to invest in balanced portfolios, with attractive return prospects across asset classes and diversification benefits from holding a combination of stocks, bonds and alternatives.
Key Contributors – Solita Marcelli, Mark Haefele, Vincent Heaney, Christopher Swann, Jennifer Liu, Jon Gordon, Alison Parums
Read the original report: Falling Yields Support Stocks, November 3, 2023.
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